before the
Subcommittee on Capital Markets, Securities
and Government Sponsored Enterprises
Committee on Banking and Financial Services
United States House of Representatives

March 5, 1997

Mr. Chairman and members of the Subcommittee, I appreciate
this opportunity to present the views of the Federal Deposit
Insurance Corporation on financial modernization and related
issues. I commend you, Mr. Chairman, and Congressman Kanjorski
for placing a high priority on the need to modernize and
strengthen the nation's banking and financial systems. Current
restrictions on the financial activities of banking organizations
are outdated. Their elimination would promote the efficient,
competitive evolution of financial markets in the United States.
One of the lessons of the 1980s is that geographic constraints
and product restrictions do not insulate depository institutions
from competitors, and can present safety and soundness problems
because of the lack of diversification.

Congress eliminated many geographic constraints by enacting
the Riegle-Neal Interstate legislation in 1994, but remaining
product barriers limit the opportunities for financial
institutions to diversify and to respond quickly and efficiently
to changes in the marketplace. To maintain the safety and
soundness of the financial system, institutions must be allowed
to diversify. Expansion of bank and thrift powers must be
accompanied by appropriate safeguards for the insurance funds.
In addition, any proposal for financial reform must also be
examined for its impact on small communities, small businesses,
and customers of financial institutions.

Mr. Chairman, I have written testimony to submit for the
record that examines financial modernization and related issues
in detail. This morning, I want to concentrate on one of those
issues, which threatens to drive our consideration of financial
modernization -- the issue of whether banks receive a subsidy
from the federal safety net.

Concerns have been expressed that the existence of the
federal safety net -- deposit insurance, access to the Federal
Reserve's discount window, and access to the payments system --
provides banks with funding advantages that could be passed on to
bank subsidiaries, thereby resulting in the undesirable expansion
of the safety net to activities for which it was not intended.

I have asked the FDIC staff to analyze whether such a subsidy, in
fact, exists. The analysis is ongoing, but based on the evidence
we have now, the FDIC staff has reached several conclusions.

It has long been widely accepted, and the FDIC agrees, that
banks receive a gross subsidy from the federal safety net.
However, banks also incur costs, both direct and indirect, that
offset this gross subsidy. The relevant question, therefore, is
not whether banks receive a gross subsidy, but whether banks
receive a net subsidy, after taking account of offsetting costs
and restrictions, that they could pass on to a subsidiary or
affiliate engaged in nonbanking activities.

It is extremely difficult to measure directly whether banks
receive a net subsidy. However, on balance, the evidence
indicates that, if a net subsidy exists, it is very small.

In addition, during the 1990s, significant changes in law
and practice have substantially reduced the gross subsidy that
the safety net provides -- these changes include minimum
risk-based capital standards, the "least cost" test for resolving
bank failures, risk-based deposit insurance, and restrictions in
the Federal Reserve's ability to lend to undercapitalized
institutions through the discount window.

As my written testimony discusses in detail, while
quantification of the gross subsidy and offsetting costs is very
difficult, the evidence shows a gross benefit of about 10 basis
points or less, and offsetting costs -- interest free reserve
requirements, interest payments on bonds issued by the Financing
Corporation, and other costs from regulation -- that, together,
are considerably higher than 10 basis points. The costs of
regulation for commercial banks alone has been estimated to
amount to more than 30 basis points.

Practical evidence also argues that the net subsidy is small
or nonexistent. Banking organizations often conduct activities
in affiliates at the holding company level that could be
conducted directly in a bank or in a bank subsidiary without any
firewalls. Examples include mortgage banking, consumer finance
and commercial finance. If there were a material net subsidy, a
rational banking organization would not carry out these
activities in holding company affiliates. It would carry them
out in the bank or bank subsidiary.

Moreover, even if a small net subsidy exists, firewalls,
such as those that require a bank's equity investment in a
subsidiary to be deducted from the bank's regulatory capital, and
the restrictions of Sections 23A and 23B of the Federal Reserve
Act -- which among other things limit the investments by a bank
in an operating subsidiary to 10 percent of the bank's capital --
serve to inhibit a bank from passing a subsidy either to a
subsidiary or to an affiliate of the holding company.

These firewalls are not impenetrable under all
circumstances. In times of stress, firewalls tend to weaken.
Our experience is that in such times, funding pressures can be
exerted on the insured bank by its holding company as well as by
subsidiaries of the bank. Nevertheless, the available evidence
indicates that both bank subsidiary and holding company
structures will work equally well in inhibiting a bank from
passing a net subsidy to a subsidiary as long as appropriate
safeguards are in place to protect the insured bank.

In addition, from the perspective of safety and soundness,
there may be an advantage to the bank subsidiary model. Allowing
a bank to put new activities in a bank subsidiary diversifies a
bank's income stream. The bank benefits from the earnings of the
subsidiary and, with appropriate firewalls, the downside risk can
be limited to excess regulatory capital -- above well-capitalized
levels -- with respect to investments in the subsidiary. In this
way, the bank subsidiary structure can lower the risk to the
insurance funds and may actually reduce any subsidy that arises
from deposit insurance.

Given these facts, we have concluded that allowing banks to
conduct financial activities in a bank subsidiary does not
represent an undue expansion of the federal safety net.
Therefore banking organizations should be free to choose how best
to organize their activities according to their business
judgments.

Because any subsidy from the federal safety net is, at most,
de minimis, the subsidy argument should not drive financial
reform.

Nor should the subsidy argument be used -- as it has been --
as justification for reducing federal deposit insurance coverage
-- or for eliminating federal deposit insurance altogether
through privatization. Such an argument diverts attention from
the real issue of whether federal deposit insurance continues to
serve the interests of the American people. As we learned the
hard way in the banking crisis of the 1980s and early 1990s,
federal deposit insurance assured the stability of the financial
system when it was under great stress. Privatizing or reducing
federal deposit insurance would diminish our ability to assure
financial stability in times of stress and, therefore, would be
detrimental to the American public we serve.

Reforms enacted by Congress in 1991 have added market
discipline to the deposit insurance system, and the FDIC
continues to focus on other reforms that would further reduce
the costs of resolving bank failures.

Mr. Chairman and members of the Subcommittee, my written
statement discusses several other important issues that I, in
conclusion, want to note very briefly this morning.

We have significant concerns about the full-scale removal of
the division separating banking and commerce. We support
functional regulation of securities and insurance activities.
We believe that regulation should be commensurate with risk -- no
more and no less. We also believe that there is room for
oversight supervision to prevent critical safety and soundness
issues from falling into the cracks and to address potential
systemic problems. That said, such oversight need not involve
regular full-scope examinations of nonbanking subsidiaries where
there is adequate functional regulation nor activity-by-activity
or investment-by-investment regulation of nonbanking
subsidiaries.

In conclusion, eliminating current restrictions on the
financial activities of banking organizations requires balancing
public policy goals and building a sound supervisory structure
for the future. I believe that we can achieve genuine reform
while assuring a strong, competitive environment for financial
services and, at the same time, addressing safety and soundness
considerations. I applaud this Subcommittee for its attention to
these issues. The FDIC stands ready to assist you in any way we
can. I look forward to your questions.